Sunday, August 18, 2013

It was Federal Reserve (Fed) Chairman Ben Bernanke who first fired the salvo by talking of an end to Quantitative Easing (QE) III. It led to a meaningful correction in the Dow Jones Industrial Average (DJIA), which lost almost 1,000 points over a month from May to June.

Sensing that investors did not like his new stance on the QE, he quickly made an about-turn by announcing to the whole world that the Fed’s decisions were not yet cast in stone and dependent on US economic data. Other Fed officials joined in the party resulting in the DJIA reclaiming the lost points plus more.

It is getting harder to survive in the market with key decision makers flip-flopping their comments, reminding us how hard the Americans in the Congress tried to argue about almost everything under the sun ranging from US debt ceiling to the rescue of the “too big to fail” corporations.

With largely improving economic fundamentals – minus some that missed expectations – nobody would doubt that the US economy is indeed rising from the ashes of the financial crisis. This means that the Fed will now have to consider an exit, which investors hope will be well communicated and properly executed.

Communications is the key as the DJIA fell 118 points on 14 August followed by another triple-digit fall after Fed officials hinted that the reduction in the bond-buying programme may come in either September or October. After Bernanke first talked about the exit plan, the DJIA lost 1,000 points and then reversed its course to gain slightly more than 1,000 points after the Fed Chairman toned down his language. Will the DJIA lose another 1,000 points after recent data showed that the US economy, especially the labour market, has indeed improved?

US Economy Leading The Way
On 15 August, the DJIA fell more than 200 points at one point after weekly jobless claims came down to 320,000 – the lowest since October 2007 – pointing to the fact that firing has stopped and hiring has accelerated. One of the key determinants of whether or not the Fed will start withdrawing the stimulus measures is the strength of the US labour market.

Yet another factor that will come into play is the inflation figure, which rose 0.2 percent in July – the third consecutive month of increase – and meets the Fed forecast. Should inflation creep up, which happens when the economy is growing and consumers who have more money in their pockets start to spend, there is no reason for the Fed to continue boosting the economy with cheap credit because flooding the economy with so much money will lead to runaway inflation just like what happened to China.

It is really just a matter of time, sooner rather than later, that the Fed will start to reduce the amount of bond-buying from US$85 billion a month to less than that. It is likely that the Fed will want to take baby steps unless economic data from now till September or October shows tremendous improvements. For a start, the Fed may trim the amount to US$70 billion or so hence we must start paying attention to what economists and analysts are predicting because the Fed will not want to cause a market meltdown by trimming more than needed.

If the Fed were to brandish the knife, it may take place on 17-18 September when at the FOMC meeting. Any bombshells before this date may probably scare investors into searching for a bomb shelter.

What else after the first cut?
I have mentioned many times that the world is addicted to government intervention. This is not healthy but definitely a necessity. Now that the thoughts have been well published, the Fed will start exiting from stimulus. By how much, investors will ask? When will the complete withdrawal take place? Will investors worry? What comes after the curtain is drawn on QE III? Will there be a rate hike? It all depends. In the opinion of the Fed officials, it will probably hinge not only on the US economy but also the economy of its “allies” in Europe and Asia.

Welcome Back, Europe! Hope For China!
After dragging the world into the fray for spending frivolously and lavishly for most parts of their lives, the Europeans are finally showing signs of a recovery! Almost all parts of Europe, including the PIIGS, have reported report cards that no longer guarantee a thrashing from the parents.

Germany, the country that manufactures Porsche, Audi and Mercedes-Benz, and France reported a good showing that promises to drag Europe out of the dark shadows of a long drawn-out recession. Both countries reported better-than-expected growth in the 2Q13. Overall, the Euro zone reported a 0.3 percent gross domestic product (GDP) growth, better than the 0.2 percent expected by economists, and that ended six quarters of consecutive contractions.

However, jobless rate still stands at 12.1 percent and it is still too early to pop the champagne as growth is still not experienced across the board. Nevertheless, even Portugal managed a solid 1.1 percent increase in GDP largely due to an increase in trade while Spain and Italy, still facing contractions, managed a lower-than-expected decrease in GDP of 0.1 percent and 0.2 percent respectively.

This spells good news, as Europe has been a drag on the global economy for the last two years, affecting China who exports most goods to the Europeans prior to the recession.

Trying to reduce its reliance on exports by boosting domestic consumption, China surprised the world by reporting much better economic data ranging from manufacturing figures to service industry figures. This caused a spike-up in both China and Hong Kong markets but the rally has come on too strongly hence markets may now look to the weakness in the US market as an excuse to sell especially when the Chinese government is adamant that it will not introduce stimulus measures despite promising that economy will grow by at least 7 percent this year.

The Tug-Of-War Has Started
The time has come for an improving economy to pit its strength against the incurable disease of stimulus addiction.

For now, the latter continues to win the battle because markets have rallied too much. Investors will still need a lot of time to unwind an addiction that has lasted for almost five years, hence so much will depend on how the Fed plans and executes its exit strategy. Too much, the market wilts; too little, the addiction stays and withdrawal symptoms in the future will not be easy to bear.

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